A Health Savings Account, or HSA for short, is a fantastic vehicle to pay for out-of-pocket qualified medical expenses which insurance does not cover in-part or in-full. It effectively allows you to get a tax deduction for nearly all of your unreimbursed expenses whether or not you itemize deductions. It also works great for those who itemize, but do not have enough medical expenses to get over the 7.5 percent or 10 percent (depending on your age) of adjusted income threshold before those deductions are counted. Many people assume they are receiving a tax benefit for these expenses when they are not. Simply look at your Schedule A, line 4. If it says $0, or if you do not even have a Schedule A, you are not benefitting from your itemized medical deductions. Even if you have a number there, line three will show you how much you are getting zero benefit from due to the threshold.

How do I Qualify and What Kind of Account Is It?

In order to qualify for an HSA, you must have a “high deductible” health insurance plan. For 2015, this means you have to have a minimum annual deductible of $1,300 for self-only coverage, or $2,600 for family coverage (or approximately the cost of breathing the air in a hospital lobby). Your plan must also have a maximum annual out-of-pocket limit of $6,450 for self-only coverage or $12,900 for family coverage. If you meet these requirements, you are eligible to set up an HSA account for yourself.

An HSA account is kind of like having a checking account just for qualified medical expenses, but is shares characteristics with an IRA account. A lot of people think the accounts are married to the health insurance providers, but they are not. Lots of banks and investment companies offer them. The account is a custodial account held for your benefit, and you get to choose the company that is the custodian, and you can move the money from one custodian to another, just as you could move your IRA from Fidelity to Vanguard, for instance. You often get a checkbook and/or a debit card. The custodian follows certain rules laid out by the IRS, and reports to the IRS at the end of each year the total contributions to and distributions from your account. The custodian is not responsible, however, for verifying that your expenses are qualified medical expenses, as that responsibility falls to you.

If you have health insurance through an employer and the plan qualifies, often your employer and its health insurance representative are instrumental in getting this account established, and they will select an initial custodian. Many employers will even contribute a monthly amount to your HSA account since the high deductible aspect often saves the employer money on the premiums. But even if your employer does not set an HSA up, you can do it. And as long as your health insurance plan qualifies, you can contribute to it.

How Do I Put Money Into the HSA?

Anyone is actually allowed to contribute to your HSA account (if you should be so lucky!), but there is a total contribution limit of $3,350 per year for self-only plans, and $6,650 for family plans in 2015. And you get an above-the-line tax deduction for the amount put into the account each year. Unlike IRAs, there are not even any income phaseouts that would prevent you from getting the tax deduction if you are a high-income earner. If your employer does not contribute enough to max out the contribution limit, you can always write a check to the account for the difference. You even have until April 15 (18 this year) to make the contribution for the prior year (similar to an IRA). If you are over 55 years old (IRAs are 50), you can make an additional $1,000 contribution each year.

If you are enrolled in Medicare or are being claimed as a dependent on someone else’s return, you cannot contribute to an HSA. In years where you change from self-only coverage to family coverage, or if you get married, or go through a divorce, stop insurance, start insurance, etc. be aware that there are special rules and limitations on contributions during those years, and you could subject yourself to a penalty if handled incorrectly. If you find that you have overcontributed for any reason, you generally have until the extended due date of your tax returns to get the money out without penalty. You do have to take out any earnings it generated as well, and those would be taxable in the year you physically take the money out of the account.

Can I Transfer Money Into My HSA from an IRA?

If you are desperate to get some additional money into your HSA, you can make a once in a lifetime transfer from your Traditional or Roth IRA to the HSA via a trustee to trustee transfer. However, it is still limited to the annual contribution cap, and it would be reduced by any other contributions you made to the account during the year! So it has very limited usefulness. If you were going to do that, your first choice would almost inevitably be the traditional IRA since the Roth IRA is already a tax-free account.

What/Who Can I Spend the Money On?

All medical expenses that would normally qualify for a deduction on Schedule A, would be a qualified HSA distribution, except for insurance. Generally, you cannot pay your health, vision, dental premiums, etc. from your HSA. Exceptions to this which you could pay from your HSA include long-term care insurance for the HSA account holder (subject to normal limits on long-term care insurance deductions found in the Schedule A instructions), COBRA insurance premiums for you, your spouse, or your dependents, or health insurance paid while you, your spouse, or dependents are receiving federal or state unemployment compensation. Also, if you are 65 or older, you can pay your Medicare and other health insurance premiums (except supplemental Medicare policy premiums) from your HSA.

For the bulk of the qualified medical expenses, you can deduct them for yourself, your spouse, your dependents, or for someone you could have claimed as a dependent except that they were disqualified simply because they filed a joint return, had gross income over $4,000, or were married filing jointly and one of the spouses could have been claimed as a dependent. If you are divorced with children, you can also pay for your children’s medical expenses whether or not you are a custodial parent or claim a dependency exemption, as long as least one of you qualifies to claim the dependency exemption.

If you take money out of the account and do not use it for medical expenses, it will be taxable income, and you will hit a 20 percent tax penalty as well. When you reach age 65, however, you can take the money out and use it for any purpose with no penalty (as opposed to 59.5 for most IRA owners). So in a lot of ways, should you never use it for medical expenses, it acts like another IRA.

Also for people that become permanently disabled, they can escape the 20 percent penalty tax even if used for nonqualified expenses.

In two weeks we will conclude the discussion on HSA accounts and discuss topics such as whether or not you have to pay qualified medical expenses directly from your HSA, strategy for large bills that exceed your HSA balance, having separate accounts for spouses, what happens to the account when you pass away, pitfalls to avoid, and a discussion of the Form 8889 itself.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. Travis can be reached at 831-333-1041.

The official name for Form 5329 is “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” In other words, “penalties on incorrect contributions to or withdrawals out of retirement accounts, education accounts, and medical accounts.”

Most people are familiar with the fact that retirement accounts such as 401(k)s, 457 plans, IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs, etc. have limits on the amount of money you can contribute each year. They also limit your ability to withdraw money from those accounts until you are generally 59.5 years old, or meet one of a handful of limited exceptions.

Most people are also familiar with fact that you MUST begin taking distributions by the time you reach 70.5 years old (with a few exceptions such as for Roth IRAs, certain employees that have not yet retired from their job, or non-spouse inherited IRAs). You can delay the distribution in the year you turn 70.5 until April 1st of the following year, but if you do that, then you have to take two distributions that year. IRS instructions are often very poorly worded on this particular matter, and often people misunderstand this important point.

Education savings accounts such as 529 plans or Coverdell ESAs as well as tax favored medical spending accounts such as HSAs and Archer MSAs also have annual contribution limits. In addition, you must use the funds for qualified education or medical expenses, respectively.

If you fail to follow the rules, either by accident or out of necessity, you will generally incur penalties, which are calculated using Form 5329 for most of these infractions.

So, how much are the penalties? If you over-contribute to a retirement plan, education account, or medical spending account there is a six percent penalty on excess contributions if you do not withdraw the excess contribution (plus any related investment earnings) within six months of the original due date of the return, excluding extensions (so by October 15 for almost everybody). Any earnings generated by the over-contribution will be treated as distributions of cash to you in the tax year the correcting withdrawal actually occurs. The rules governing distributions (discussed later) will apply and you may be subject to penalties on that portion. The custodian of the account will calculate the related earnings that need to be pulled out of the account when you inform them of the need to withdraw funds.

If you over-contribute for multiple years in a row before realizing it, the penalty compounds. So you would file a Form 5329 for each of the past years (no 1040X needed) and pay six percent on the excess contributions for the year of the 5329 you are filing, plus any prior excess contributions that still had not been taken out. In other words, you pay six percent every year on the excess contribution until you take it out. Interest would also be assessed on top of the penalties.

If you fail to take a Required Minimum Distribution (RMD), the penalty is 50 percent of the amount that was supposed to be taken out, but was not. Unlike the six percent over-contribution penalty that applies every year until you take the funds out, the 50 percent penalty only applies once. But you would need to withdraw the funds and file a 5329 for each past year you failed to take an RMD. Interest would also be assessed on top of the penalties. Fortunately, the IRS has been pretty lenient with the steep 50 percent penalty, and you can often get them to waive the penalty for reasonable cause once you withdraw the money.

Early distributions for all retirement accounts that do not qualify for an exception are subject to a ten percent penalty, (plus inclusion as taxable income for the portion related to original contributions for which you received a tax deduction as well as on any earnings generated while in the account). SIMPLE IRAs have a special rule that increases the penalty to 25 percent if the date of your first contribution to the SIMPLE IRA was less than two years ago.

Distributions from education savings accounts for nonqualified purposes are subject to a ten percent penalty.

Distributions from medical spending accounts that are not used for qualified purposes are generally subject to a 20 percent penalty. These 20 percent penalties, however, are calculated on different forms (8889 for HSAs and 8853 for MSAs). With HSAs when you reach 65, you can use the money for whatever purpose you want, without penalty. You can also rollover an MSA into an HSA.

Regarding the Form 5329 itself, the first two parts deal with distribution penalties for retirement accounts and education accounts (health account distribution penalties are calculated on other forms). The third through seventh parts deal with excess contribution penalties for each different type of account. The final section, part VIII, deals with penalties on RMDs not distributed.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Believe it or not, time is actually starting to run out if you plan on filing your taxes by April 15. Many firms require complete information to be in the office by late March or the beginning of April in order to assure the returns are completed by the April 15 rush. Most people understand that personal tax returns and any tax owed are due on that day. Even if you file a 6-month extension for the return, the tax is still due on April 15. This requires you to consider the possibility of a short-fall and then send in an estimate by April 15 if deemed necessary, otherwise you will incur interest and penalties if you underestimate.

There are a number of charges the taxing authorities stack up to collect a little extra flow for the general treasury if you are delinquent, and they are all based on unpaid tax. There is a late return penalty, a late payment penalty, an underpayment of estimated tax penalty, plus interest! If you have ever seen the play Les Miserables, it can seem a bit like the opportunist innkeeper, Thenardier who sings, “Charge ’em for the lice, extra for the mice, two percent for looking in the mirror twice! Here a little slice, there a little cut, three percent for sleeping with the window shut.”

In two weeks we will discuss filing extensions and cover the penalties that can start accruing after April 15 – those include late return penalties, late payment penalties, and interest. This week we will focus on the penalty that can accrue throughout the past year up until April 15 – underpayment of estimated tax. If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .

Underpayment Penalties and Form 2210

While underpayment of estimated tax sounds like a concept that would just apply to people that make quarterly estimated taxes, the reality is that it applies to all of us. It even applies to those that file their returns on time and pay all of their taxes by April 15th. So why would you owe penalties for being such a model citizen?!

Think of it like this: if your employer decided that paying you every two weeks for the wages you had earned was too much of a hassle, and decided instead they were just going to cut you a check once a year in December (or heck, how about April 15 of the following year – why rush it!), you may have a difficult time paying your bills throughout the year, and would then have to borrow money and pay interest on it to carry you until you got your next annual paycheck.

Even if you were a superb money manager and budgeted your annual paycheck carefully so you wouldn’t have to borrow money, you would still conclude that this is an unfair deal and demand that they pay you some interest since you do not particularly fancy giving your employer a free loan for a year! The taxing authorities are the same way. Their “paycheck” is the taxes you owe them and they want to get paid throughout the year, or at least get compensated for your continued use of their paycheck. California and the federal government do not exactly have stellar records of managing money (what government does?). As such, they have to issue bonds to borrow money to cover their expenses and then are stuck paying interest on the bonds! So they want their paycheck!

Employees have taxes taken out of each paycheck and remitted regularly by their employers. Self employed people do not, and generally must pay quarterly estimates. But in either case, if you come up short at the end of the year, the taxing authorities will assess “underpayment penalties” if you do not meet certain thresholds.

So when are underpayment penalties assessed? In the simplest calculation, the federal taxing authorities take your total tax liability at the end of the year, divide it by four and assume they should have received 25 percent by April 15, 25 percent by June 15, 25 percent by September 15, and 25 percent by January 15 of the following year. They look at the dates and amounts sent in by you and then figure out how much your were short and for how many days. They then assess the three percent rate on those figures and amounts of time. California has a special schedule which requires 3o percent paid in April, 40 percent paid in June, 0 percent in October, and 30 percent in January. This unequal schedule requiring 70 percent of your tax to be paid in during the first five months of the year was California’s little trick to help balance the budget a few years back.

You also may be wondering why it is June 15 and September 15 instead of July 15 and October 15, as June is only two months after the first quarterly payment was due (but you owe it on income for three months!). The answer is that I have no idea. I heard once that it had to do with a projected budget short fall by Congress many decades ago, and they were trying to balance their budget. That would make sense, but I can’t say for sure.

If you have taxes withheld by your employer or another source, for calculation purposes, they are evenly spread out to the four quarters, no matter when the taxes were actually paid. For instance – if you got a large bonus at year-end, the taxes would be allocated evenly to all quarters. This makes sense since in the default calculation, the income is also spread out evenly to all quarters.

Self employed people can have problems with this, however, since the actual dates of the estimated tax payments are used in their cases, but the income is still spread out evenly by the default calculation. This could create unjust penalties if they earned a big chunk of their revenue near year end, and then sent in a check at year-end. The revenue would be spread out to all quarters, but the taxes would look delinquent since they were paid at year-end. The Form 2210 allows you to correct this by using an annualized income installment method whereby you enter in your year-to-date cumulative net income (as well as other income and deductions) at the end of each quarter to change the calculation method, and avoid these penalties.

Fortunately, there are some general rules that may allow us to be “penalty proof” so we do not have to worry about this every year, 1) If you have paid in at least 90 percent of the current year tax liability you are penalty proof, or 2) If you paid in at least as much tax as your tax liability in the prior year, then you are penalty proof unless your income is over $150,000 (75,000 if Married Filing Separate), then simply paying in at least as much tax in the prior year will not qualify you – you will have to pay in 110 percent of the prior year amounts, or 3) If the net tax you owe is less than $1,000 after subtracting out payments you made by April 15, then you are penalty proof. California conforms to all of these federal rules. It also has an additional rule for taxpayer’s that make over $1,000,000 ($500,000 Married Filing Separate) – those taxpayers are required to pay in 90 percent of the current year tax or they will face penalties.

Contrary to its unfortunate label as a “penalty,” it is essentially just interest. And it is currently at that same rate of three percent per annum. I often have clients that say they hate paying penalties and want to do whatever they can to avoid underpayment penalties. When I ask them if they would like a loan at a three percent rate of interest instead, they want to know where they can get more of it! If you are going to owe a substantial sum and would need to take the money out of investments that are almost certainly earning more than three percent in todays markets, it would be a wise decision to pay the penalties and pocket the spread. If your money is just sitting in a bank account, however, it would be a different story.

In addition to the calculation sections, the Form 2210 also has boxes to request relief from late payment penalties.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Change is challenging, and the current health reform laws are no exception. And it is exceptionally challenging when the laws are constantly changing, vague, impossible to follow, or impossible to enforce! In light of that commentary, I would like to enlighten business owners that they are supposed to notify employees of health care coverage options and the Health Insurance Marketplace by September 30th, even if they do not have or intend to provide health insurance.

The United States Department of Labor website contains two model notices that you can easily adapt and provide to your employees. One of the notices is designed for employers that have a health insurance plan. The other notice is designed for employers that do not have a health insurance plan and do not intend to provide health insurance.

If you go to http://www.dol.gov/ebsa/healthreform/ and look in the section titled “Notice to Employees of Coverage Options,” you will see the two notices and can even download the one you need as an editable Microsoft Word Document. You can then fill out the section that provides contact information for the person in your company that can handle questions. If you pick the notice for employers that have health insurance, then there is also a section to fill out about your health insurance plan. Then you simply give them to your employees.

The notices essentially make people aware that the new law requires people, in most circumstances, to carry health insurance starting January 1, 2014, with an open enrollment period beginning October 1, 2013. It also makes them aware they should be able to purchase health insurance through a Health Insurance Marketplace if their employers do not offer affordable coverage that meet certain standards. The notices also try to explain there could be some tax benefits to assist with paying premiums depending on income levels.

It would be nearly impossible to enforce and unfair to penalize for noncompliance regarding this notice to employees given the mess the country is in trying to implement the Affordable Care Act. Fortunately, the government recognizes this as well, and is saying they will not penalize businesses for failure to notice, even though the businesses should provide notification.

For people that fail to obtain health insurance, a self-imposed penalty is supposed to be reported on your 2014 tax return equal to the greater of two calculations. The first calculation is one percent of the difference between your Adjusted Gross Income (AGI) and the minimum AGI required to file your tax return. The second calculation is $95 for yourself and each of your dependents ($47.50 per person under 18) up to a maximum of $285. Most people will therefore be looking at the one percent penalty. In order to enforce this law, the IRS will be looking for statements from employers reporting details of employee coverages in company plans. This reporting will be voluntary for 2014, which means many businesses will not report, and it will be very difficult for the IRS to enforce the penalty short of discovering it through an audit process. In 2015 and 2016, the penalty is expected to rise substantially.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

My grandfather’s sister once had the opportunity to go toe-to-toe with the 1920s gangster, Al Capone…or so goes the family story. She had ordered a fancy car and Capone sent a couple of his henchmen to convince her that she should allow him to purchase it since he did not want to wait for another one to be built. She politely refused, at which point, they said Mr. Capone would like to talk with her in person. So she drove to his place in Palm Island, Florida to meet the notorious gangster. She was a rather outspoken individual, and managed to come out with her car, and did not even have to dodge bullets on the way past the front gate! Most people know the interesting story about Al Capone is that the Feds could never get him for bootlegging, racketeering, prostitution, or murder, but they nailed him for tax evasion and failure to file tax returns!

Fast-forward the better part of a century and we are battling terrorism. Sometimes it is difficult to prove that a particular individual was involved in an act of terrorism, but there may be other ways to get them. How about the failure to report foreign accounts or even having signature authority over foreign accounts while residing in the United States?

Form TD F 90-22.1 Report of Foreign Bank and Financial Accounts is required to be filled out each year for anyone that has bank or financial accounts (or is an eligible signer on someone else’s foreign accounts) that were established in a foreign country that aggregate $10,000 or more. The form is due to the Treasury Department each year by June 30th (one month away). Note this form does not go with your tax returns to the IRS. The IRS has its own two-year old Form 8938 Statement of Specified Foreign Financial Assets which is more geared towards tax evasion and is filed with your returns. It covers some additional assets and has different reporting thresholds, so you and your tax professional should review that as well.

The penalties for failure to file Form TD F 90-22.1 can be pretty sickening. Willful neglect to file the form is punishable with civil and/or criminal penalties. Civil penalties could be the greater of $100,000 or half of the account value. Criminal penalties could be $250,000 plus five years in prison, or $500,000 and 10 years in prison if you are also violating another law simultaneously. Even non-willful neglect (a.k.a. – your ignorance) carries a penalty of up to $10,000. These are also applicable per year you fail to report!

The IRS was recently seeking six years in prison for a 79 year-old widow in Palm Beach, FL for such issues and related failure to report the income from foreign accounts. I think the key is to just make sure you file the forms as needed, and have a discussion with your tax professional or an attorney if you are unclear if your assets qualify you to file these forms.

Oh, and if you happen to know any terrorists that need to file, please don’t forward my contact information…

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Imagine opening a letter from the IRS assessing you an $18,000 penalty because they claim you did not file your extension on time! I once worked with a client that was faced with this exact problem. The irritating part is that an extension request is an arguably meaningless filing since it is automatically granted if requested. Nonetheless, the IRS takes it seriously.

So with April 18th fast approaching (taxes are not due on the 15th due to the federal observation of the signing of the Compensated Emancipation Act by Abraham Lincoln in 1862), how can you protect yourself? If you are filing your own extension for your personal tax returns with the IRS use Form 4868. Be sure to get some kind of proof of delivery and make a copy of the extension. Even with delivery confirmation it is difficult to prove what you sent. The best way is to e-file the extension through home-use tax software or by using a tax professional that e-files and obtains an electronic confirmation. What about California? In the midst of a tiresome sea of nonconformity with the IRS, I applaud California for this one act – you need not file a form to be granted an automatic extension! After you have filed your federal extension you have until October 15, 2011 (six months) to file your returns.

BEWARE!! Just because you file an extension does not grant you additional time to pay! The tax you calculate on the return you are going to prepare and file by October is still due by April 18. So if you think you might not have enough tax withheld, you need to make some good estimates and send in some checks. You may want to hire a tax professional to help with this calculation. You can send the federal check with Form 4868. For California, you can use FTB Form 3519 to send with your check. There are also electronic options for paying both of these.

If you do not pay your tax or file your return on time, interest and penalties are calculated based on any amount of tax you come up short. Interest varies with market changes (currently 4 percent a year for the IRS). IRS late payment penalties are ½ percent of the balance each month (up to 25 percent). If you fail to timely file, the IRS penalties are 5 percent of the balance each month (up to 25 percent). You may also incur underpayment of estimated tax penalties depending on your circumstances. California interest and penalties are similar or higher.

Oh, and remember my client with the $18,000 penalty – fortunately we were able to successfully petition to get the penalty waived!

Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA. Travis can be reached at 831-333-1041.